By Robert Gordon and Mark Fichtenbaum
Twenty-First Securities Corporation
Originally published by the Journal of Taxation of Investments
Delta Hedge Publications: Brooklyn, NY, Autumn 2003.

New Tax Law Means New Opportunities

The 2003 Tax Act¹ reduced the rate of tax on both long-term capital gains and dividend income earned by individuals to a maximum rate of 15%.  Though it makes long-term gains more interesting, that in itself probably will not change many people’s investment behavior.  The change in the rate of dividend taxation (more than a 50% decrease) should change the investment behavior of individual investors.  However, certain limitations that investors must be wary of were also imposed in order to obtain the lower rate.  These limitations mirror in many ways Section 246, which governs corporations wanting to utilize the dividends received deduction.  This article will focus on some of the limitations and traps that investors will have to deal with under the new law, as well as discuss some of the ambiguities still left unanswered.

Qualifying Dividend Income.  In order to obtain the 15% tax rate, the dividend must constitute qualifying dividend income (QDI).  In order to be QDI, certain requirements must be met.  First, the corporation making the distribution must have sufficient earnings and profits, which is no different than the old law.  The tax writers did not incorporate the new concepts of REBA² and CREBA³.  Second, the shareholders must have held the stock for more than 61 days.  During this period, any day in which the investor has diminished its risk of loss with respect to the stock is not counted.

Are Your Calls Qualified Covered Calls? Under the American Jobs Creation Act of 2004, writing in-the-money calls suspends the holding period required to capture dividends or the DRD.  See Tougher Rules For Hedging Dividends.

Here is where the long history of Section 246 and its subsequent regulations are referenced.  In short, one cannot own a put, and one can only sell a Qualified Covered Call (as defined in 1092(c)).  These calls cannot be too deep in-the-money.  Since the introduction of this exception in 1984, the rules were further tightened in 2002⁴.  These new regulations limit qualified calls to a maximum of 33 months and are the first to introduce the concept of forward pricing of securities to U.S. taxpayers.⁵  It is unclear whether an investor could sell more than one call for every hundred shares and still not interfere with the requisite minimum 61 days.  If so, “rocket science” would tell you that by dynamic hedging, you could completely manage the investment risk.

The 1984 law also contemplated holding a portfolio of dividend paying stocks and hedging with an index.  It was declared to not stop the holding period as long as the portfolio and the index do not “mimic” each other.  The “mimic” standard was not detailed until more than ten years later when, in Reg. Sec. 1.246-5, the government ruled that the portfolio and index could not overlap each other by more than 70% (on a capitalization basis).⁶  The government thought this a better approach than to have taxpayers making and relying on regression studies and perceived tracking error.

It should be noted that the holding period rules must be met by a mutual fund for the fund to pay out a 15% dividend.  In addition, the holder would need to hold that fund for more than 60 days.

Day Count Problem Fixed

Dividend Day-Count Problem.  A problem that needs fixing is in the counting of days.  The holding period must be met during a specific time period of 120 days beginning 60 days before the ex-dividend date.  If an investor buys stock one day prior to the ex-dividend date, it is the last day the investor is entitled to the dividend.  However, the date of acquisition is not counted in determining the 61 day holding period.  There would only be 60 days left in the 120 day qualifying period.  Therefore, the investor will fall one day short of meeting the holding period requirement and that dividend will be taxed at 35%.  While this result was probably not intended, it appears to be the outcome.

Hedging.  Another ramification of the more-than-60 day holding period for QDI will be that investors who have entered into hedging transactions to protect their appreciated stock will not have their dividends be treated as QDI.  In 1997, Congress changed the law so that this holding period must be met for each and every dividend.  The possessor of a collar, forward sale or put has stopped accruing holding period on their stock.  Wall Street’s challenge is to devise a strategy, which would give the investor protection and allow the dividends to be treated as QDI.  Stay tuned.

Foreign Stock Investments: The ADR Advantage

Foreign Corporation Dividends.  Dividends from both domestic and certain foreign corporations will be treated as QDI.  In order for the dividends from the foreign corporation to be QDI, the corporation must either (a) be incorporated in a possession of the United States, (b) such corporation is eligible for the benefits of a comprehensive income tax treaty with the United States which the IRS determine is satisfactory for these purposes or (c) such corporations’ stock is “readily tradable on an established security market in the United States”.  This creates an ability for U.S. citizens to invest in “non-treaty” countries and still get a reduced 15% tax on their dividends.  It is being debated in Washington whether this generous treatment will be afforded all ADRs traded here or whether 144A shares⁷, or those like Heinekin, that chose not to conform to our accounting standards and thus trade in the “pink sheets”, do qualify.⁸

While the inclusion of dividends on foreign stock as QDI is positive, it is unclear as to whether a foreign corporation would keep records of its earnings and profits as computed under the rules of the Internal Revenue Code.  This could be an issue for shareholders of foreign companies who receive a distribution in those years that the corporation is suffering losses or if the corporation makes an extraordinarily large distribution.

Differences Between Individuals and Corporations.  There are two areas where the rules for individuals differ from those for corporations. First, investors will be able to borrow against dividend paying shares and take an interest exense deduction (Section 246A denies this to corporations).  Investors will not be able to obtain a tax advantage by leveraging the purchase of a dividend paying stock unless they possess other investment income as defined in Section 163.  This is because interest expense incurred by an investor used to finance the purchasing of stock will normally be treated as investment interest expense.  Investment interest expense may only be deducted against the investors’ investment income.  Investment income includes interest, dividends which are not QDI, and short-term gains.  QDI is not treated as investment income unless the investor elects to treat it as such.  Long-term gains, as well, are not considered investment income unless the investor so elects.⁹  Therefore, to the extent the interest expense is being used to offset the dividend income, there is no tax benefit to be discovered from a difference in tax rates.

Extraordinary Dividends.  The other area of difference is the treatment of those receiving “extraordinary dividends” as defined by Sec. 1059 to be more than 10% of a holder’s basis.  For a corporation to get the favorable dividend treatment, it must hold the shares for two years before the dividend is paid.  For individuals, the new rules grant a 15% rate to the extraordinary dividend but make any loss upon sale long-term up to the amount of the dividend,¹⁰ in order to dissuade investors from attempting to benefit from a short-term investment in a stock that is about to pay a large dividend. Without this rule, investors might buy the stock, accrue the 61 day holding period, and then sell the stock.  This type of investment would allow the investor to receive QDI taxed at 15%, and incur a short-term capital loss, which could be used to offset other short-term capital gains otherwise taxed at a 35% rate.  The new law, however, will treat the loss as a long-term capital loss, since long-term gains are only taxed at 15%.

“In Lieu” of Payments Not QDI.  Investors who hold dividend-paying stock in a leveraged margin account may, however, be falling into a trap.  When shares are held in a margin account, and the investor has borrowed against the account, the broker may borrow shares from the investor equal to 140% of the debit balance.  If the broker borrows the shares over a dividend payment date, then the investor will not receive a dividend from the corporation.  Instead, the investor will receive an “in lieu” of dividend payment.  “In lieu” of dividend payments do not qualify as QDI.  Instead, they will be taxed as ordinary income.

To date, most brokers do not have systems in place to track such payments and this year investors will not be required to treat an “in lieu” of dividend payment, as such, if they do not have any knowledge of its character.  However, in 2004 brokers are obligated to track such payments that will not qualify as QDI.  Investors should transfer their high dividend paying stock to a cash account if at all possible, from which they cannot be borrowed.  Advice will need to be given on how brokerage firms should allocate which customers’ shares were indeed borrowed.

Long-Short Strategy.   One investment strategy, known as “long-short” will obtain a benefit due to the changes in the law.  Under a long-short strategy, an investor will purchase a number of stocks and sell short other stocks.  The goal is for the stocks that the investor owns (long) to outperform the stocks that the investor has sold short.  The types of income and expenses that such investor should incur are the following:

1. Gains or losses incurred upon the closing of their positions,
2. Dividend income,
3. “In lieu” of dividend expenses, and
4. Interest income on the short sale proceeds.

As long as the investor meets the 61 day holding period, the dividends it receives should be QDI.  Additionally, as long as the investor is short a stock for more than 45 days, the “in-lieu” of dividend payment will be treated as investment interest expense for tax purposes.  Gains and losses from closing the long positions will either be long or short-term capital gains or losses depending upon their holding period, but all gains and losses with respect to the short positions will be treated as short-term.  Many of these investors end up with similar amounts of dividend income and in lieu of dividends expense.  Their economic income is usually equal to their net capital gains and the interest income earned on the short sale proceeds.  However, under the new law, the dividend income will be taxed at a maximum rate of 15%, while the “in lieu” of dividend expense may be used to offset the interest income and net short-term capital gains earned from the investments, taxed at a 35% rate.  The after-tax rate of return from profitable “long-short” investing has been increased as a result of the change in the law.

Conclusion.   While there is a reduced rate of tax imposed upon dividend income received by individuals, investors must ensure that they comply with all of the attendant rules in order to insure they pay the lower rate.

Endnotes:

1. The Jobs and Growth Tax Relief Reconciliation Act of 2003, PL 108-27 (signed May 28, 2003).
2. Retained earnings Basis Adjustment.
3. Cumulative Retained Earnings Basis Adjustment.
4. TD 8990, 67 Fed. Reg. 20896 (April 29, 2002).
5. Reg. 1.1092(c)-1(b)(2).  A QCC is a call on the stock that meets the following criteria:  (1) The call is not written by a dealer in these calls, (2) there must be listed options traded on the stock, although the actual call that is written does not have to be listed, (3) the term of the call may not be less than 30 days or greater than 33 months, and (4) the call may not be a “deep in the money” call.  A deep in the money call is one that is more than one strike price below the closing price of the stock on the day before the call is written.  However, for calls with a term of greater than one year, the closing day’s stock price is increased by 2% for each quarter of a year or part thereof that the call has until expiration.
6. TD 8590, 60 Fed. Reg. 14636 (March 20, 1995). 
7. Wee 17 CFR 230.144A, Private Resales of Securities to Institutions.
8. See William S. Dixon, “Qualified Dividend Income and Foreign Corporation Shares: A Few Areas of Uncertainty, 17 J. Taxation and Regulation of Financial Institutions 26 (September/October 2003). 
9. Act section 302(b), amending Section 163(d)(4).
10. Act section 302(a), adding Section 1(h)(1)(D)(ii).
    
    

 

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".